Data processing: financial – business practice – management – or co – Automated electrical financial or business practice or... – Finance
Reexamination Certificate
1999-10-06
2004-12-14
Olszewski, Robert P. (Department: 3627)
Data processing: financial, business practice, management, or co
Automated electrical financial or business practice or...
Finance
C705S037000
Reexamination Certificate
active
06832209
ABSTRACT:
BACKGROUND OF THE INVENTION
This invention relates to a method and apparatus for investment of funds. More particularly, this invention relates to a method and apparatus which will benefit from investing in financial instruments whose value is expected to decrease relative to the overall market as well as those whose value is expected to increase relative to the overall market.
A wide variety of investment strategies are known to those in the field. Pure long strategies aim to invest in stocks, bonds, or other financial instruments whose value is expected to appreciate. One method is to invest in a pool of stocks which simulate an index such as the Standard and Poor's 500 Stock Index or the Dow Jones Industrial Average. Another method is to invest in individual or multiple equities whose value is expected to appreciate faster than the indices. A variety of techniques are used to select these equities ranging from analysis of the chart patterns of price and volume history for the equity to fundamental analysis and projections of the underlying business of the company represented by the equity. These methods are referred to as being long or taking long positions. Another method of investing seeks to benefit from financial instruments whose value is expected to decrease. In this method, said instruments are borrowed and sold, in the expectation that the borrowed instrument can be purchased and returned in the future at some lower price. This technique is referred to as selling short or taking short positions. This short selling technique is also commonly used by hedge funds. Short selling generates a cash position and the investor can earn an interest return on this cash.
When the value of the financial instruments that are held is greater than the amount of capital being invested, the position is described as leveraged. The use of leverage is common for long, short, or combined investment strategies. The amount of leverage available is often limited by regulation so as to limit risks. Regulatory changes in 1996 and 1998 have allowed investors to utilize higher leverage amounts. The amount of leverage can be expressed as the ratio of the value of total long plus short investments to the capital invested, expressed as a percent. Thus, if $100 is invested to purchase $100 worth of financial instruments and to sell short $100 worth of financial instruments, the leverage is 200%. The portfolio will be described as 100% long and 100% short. If the investment manager is successful at choosing better performing longs and/or shorts, then the use of leverage will multiply the benefits to the investor.
Many professional managers or management companies invest in baskets of financial instruments, for example stocks, and sell interests in these investment pools to the public. The most common examples are called mutual funds. They mainly use long strategies. Mutual fund investments often produce undesired taxable income for their investors. Even if an investor in a mutual fund or similar entity does not want to sell but rather hold the fund for long term growth, taxable income for that investor will often be generated because the fund chooses to sell some of its holdings for gains. Such sales may also be necessary to generate cash if a party decides to redeem from the fund. The investor will then have to pay income tax and reduce the amount of capital available for investment. Mutual funds which have low turnover, meaning infrequent changes in their portfolios, reduce this problem. Many of these are index funds such as the Vanguard S & P 500 Index Fund. A few funds, for example Vanguard Tax-Managed Balanced Fund, go even further to avoid the generation of taxable income. When positions are sold for gains, they also attempt to offset the gains by selling some of the positions in which they have losses. These tax minimization strategies do, however, limit the flexibility of the funds to change their holdings to take advantage of new circumstances. These funds do not use leverage or strategies which combine long and short positions. Nor do they attempt to isolate short term losses which might be useful to the investor to offset capital gains he may have in other holdings.
Some investment strategies combine both long and short positions. This allows the investment manager to take advantage both of opportunities which are undervalued versus the overall market and opportunities which are overvalued. Such portfolios are discussed in the article by Jacobs and Levy in the Financial Analysts Journal, September/October 1996. A common type of long-short portfolio is a market neutral portfolio. This approach is further discussed in chapter 10 of a book by T. Daniel Coggin and Frank J. Fabozzi entitled
Applied Equity Valuation
, published by Frank J. Fabozzi Associates, New Hope, Pa., 1998, and in a book edited by Jess Lederman and Robert A. Klein, entitled
Market Neutral
, published in 1996 by Irwin Professional Publishing, Chicago, Ill., especially chapters 1 and 5. The return on a market neutral fund can depend only on the skill of the person who selects the securities or other financial instruments. Positive returns can be achieved independently of moves in the overall market. If the overall market moves up, positive performance can be achieved if the longs perform better and/or the shorts perform worse than the overall market. If the overall market drops, positive performance can again be obtained if the longs perform better and/or the shorts perform worse than the overall market. Several market neutral mutual funds are available to the public. These are discussed in a Wall Street Journal article of May 13, 1998 and information is also available in fund prospectuses. These funds seek to capitalize on long and short stock picking judgments to yield higher returns than conservative fixed income instruments while maintaining low risk. They do not use leverage to multiply the value of the judgments and do not attempt to manage the tax consequences to the investor.
Market neutral investments are also available as private placements to qualified investors. The prospectuses for such investments are not public documents since they are offered only for purposes of evaluating the investment. Both public and private market neutral funds are discussed in volume 2 of the Journal of Hedge Fund Research, Fall 1995, pages 1-18. Many market neutral investments seek to get better returns than low risk investments such as treasury bills without incurring high risks of losses that might be present in other investment instruments. The article mentions the use of leverage as high as 400%. Other market neutral approaches target higher returns by accepting higher risks. These can also be leveraged. However, these investment approaches focus on the security selection and are relatively insensitive to the tax consequences. This is a disadvantage to the tax paying investor who may have to reduce his total capital under investment in order to pay the taxes incurred. Funds which are structured as limited partnerships or other pass through entities can avoid some of the problems of taxable income by distributing securities instead of cash to investors who choose to redeem. However, they will still cause taxable income to the investors when they sell assets which have increased in value or cover shorts which have decreased in value. The taxable income will frequently occur as short term capital gains. Under current tax laws in the United States, these occur when an investment is held for less than 12 months before it is sold. If the investments are held for 12 months or more before sale they will generate long term capital gains and these will be taxed, albeit at a lower tax rate according to current United States tax law. The gain or loss on a covered short is treated as short-term no matter how long the position has been held.
The particular instruments to be purchased or sold short may be selected by a variety of techniques for predicting expected returns. One family of techniques relates to the analysis of charts of the
Karp Jeffrey M.
Karp Ronald A.
Berkowitz Leonard
Gort Elaine
Olszewski Robert P.
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